Severance Pay and Deferrals

[Guest Tim Howard]

Please help settle this - Can a participant receiving severance pay on account of termination continue to actively participate in an employer's 401(k) Plan beyond their last day worked?

I think not, but a former colleague says its OK. I have a lunch bet on this.

[Alf]

No. You are right.

I am not sure about the technical basis for thier argument, but the IRS has consistently made it clear that severance pay that is paid before an employee's last day of work can be deferred, but ANY compensation paid after the participant terminates employment cannot be.

If you re-post this on the 401(k) board you are sure to get the right cites.

[bzorc]

I agree, but what about this scenario:

Company establishes early retirement program, paying 18 months of severance pay. Company allows those opting for the early retirement feature to defer (both pre and post tax) for the 18 month period.

OK or not? Supposedly this had the blessing of an ERISA attorney.

[pjkoehler]

The answer to your question is specific to the definition of "compensation" for elective deferral purposes in the plan document. The Sec. 401(k) regs require a defintion of "compensation" that satisfies the nondiscrimination requirements of the Sec. 414(s) regs. Reg. 1.401(k)-1(g)(2).

The Sec. 414(s) regs provide a general test that in theory a plan can satisfy with the inclusion of the "severance pay" and 2 safe harbor defintions (1) "compensation" as defined in the Sec. 415 regs and (2) and an "alternate safe harbor." Reg. 1.414(s)-1©.

The Sec. 415 regs provide their own "safe harbor" definitions: (1) "wages" as defined in Sec. 3401(a) for income tax withholding purposes, plus any other payment that the employer must report in a written statement to the employee and (2) Sec. 3401(a) wages alone. The first 415 safe harbor is broad enough to encompass severance pay, while the second one is not. Therefore, a plan definition of "compensation" that includes severance pay may satisfy a 414(s) "safe harbor."

The "alternate safe harbor" expressly excludes "welfare benefits," which probably means a defintion that includes "severance pay" would not be within this particular "safe harbor."

Since most plans are designed to avoid the complex general testing under the 414(s) regs, they often use a "safe harbor" defininion. The only way to answer your question is to review the plan document's definition of "compensation." If it uses a "safe harbor" determine which one it's within. If it doesn't use a safe harbor, then, regardless whether you analyze the defintion as inclusive or exclusive of severance pay, determine that the plan is being tested each year under the general test for nondiscriminatory compensation.

[This message has been edited by PJK (edited 05-17-2000).]

[KJohnson]

I always thought that the issue was not the definition of compensation, but that elective deferrals could only be made by employees and the definition of "employee" (incorporated from the 410 regs) requires an individual to perform services for the employer. The IRS's problem seems to be that these individuals who are receiving severance are no longer "employees."

[pjkoehler]

I think KJohnson's comment confuses the significance of the timing of the cash or deferred election and the timing at which the compensation subject to the election would have been paid or made available. The 401(k) regs provide: "But for section 402(e)(3) and 401(k), an employee is treated as having received an amount contributed to a plan pursuant to the employee's cash or deferred election. This is the case even if the election to defer is made before the year in which the amount is earned, or before the amount is currently available." Reg. 1.401(k)-1(a)(2)(v). To make an election, the person must be an "eligible employee," which is defined as an employee who is directly or indirectly eligible to make the election for all or a portion of the plan year. Reg. 1.401(k)-1(g)(3). If a person has to be an "employee" when the amount is contributed to the plan, then, for example, bonuses accrued during employment, but not paid until after termination of employment, would not receive pretax treatment, even if they were specifically subjected to a valid pre-existing cash or deferred election. That stretches the definition too far.

Clearly, a person who is not an "eligible employee" cannot make a valid cash or deferred election. But that's not the issue considered in this thread. The issue here is whether a valid cash or deferred election governs a specific component (severance pay) of "compensation." This unavoidably requires an analysis of whether that component is part of the "compensation" subject to the election. It can be argued that "severance pay" is not payment for the performance of services, but payment for the loss of a job, which is what makes it a "welfare benefit." But under the 414(s) safe harbor definitions, such a classification is not dispositive, since the 415 definition, incorporated by 414(s), includes taxable welfare benefits, e.g. severance pay.

Assuming that the plan document supports the inclusion of severance pay as a component of "compensation" for deferral purposes, there may be an issue as to the length of the severance payout. The IRS could attack a lengthy payout period (e.g. beyond the end fo the taxable year in which the employee terminated) as allowing for the deferral of "compensation" that was not in connection with the employee's "performance of personal services actually rendered in the course of employment. . . . " See Reg. 1.415-2(d)(2)(i). Under the 414(s) regs the only safe harbor definition that allows welfare benefits to be included is compensation that satisfies the Sec. 415 regs. It can be argued that includible compensation must have a nexus to the employee's performance of services. In informal conversations with IRS National Office staff, I have been informed that the Service would probably not question lump sum severance benefits or periodic benefits that do not run beyond the end of the taxable year in which the employee terminated as "compensation" subject to a valid deferral election. To the exent such benefits run beyond this point, the Service would apply a facts and circumstances test to analyze whether the compensation was for the performance of services (i.e. had some employment nexus) or was instead purely payment for the loss of the employee's job.

[This message has been edited by PJK (edited 05-17-2000).]

[This message has been edited by PJK (edited 05-18-2000).]

[This message has been edited by PJK (edited 05-18-2000).]

[KJohnson]

I am not sure that the IRS is on board with PJK's analysis and appears to apply a "bright line" test on whether the employment relationship was terminated at the time of the deferral. I suppose they could base this on the idea that once an individual is no longer an "employee" there can no longer be a valid salary reduction agreement. The following is a Q&A published by the ASPA from their 1999 session with the Service.

Q. What is the IRS position on elective deferrals from certain payments following the termination of employment, such as severance pay, accumulated vacation pay, and bonuses?

A. These payments are not eligible to have any part of them deferred under 401(k) since the participant MUST be an employee in order to defer and the employment relationship has ended prior to the payment of these amounts.

They made a similar response at the 1998 ASPA conference:

Q. What is the IRS position on elective deferrals from certain payments following the termination of employment, such as severance pay and accumulated vacation pay?

A. IRS Response: We do not believe that deferrals can be made by someone who is not an active employee. If payments classified as above are paid PRIOR to the termination of employment, the participant can defer from those amounts (assuming the plan otherwise allows such elections). If the participant has separated from service and these amounts are paid at a later time or over a period of time, no deferrals may be made.

Thus the IRS appears to concentrate on the employee's status at the time of the actual deferral rather than the time of the election. They do not even go the "extra step" to determine whether the employee is seeking to defer "compensation" as defined in the plan document.

PJK's analyis may be of help if a plan allows continued deferrals and this is challenged by the IRS. However, PJK's informal conversations with the IRS compared with the comments the IRS has made at the ASPA conference and in other venues, indicates that the Service might not be of "one mind" on this issue. I suppose that if you specifically allow continued deferrals in your plan and flag it in your cover letter when you seek a determination letter you can rest easy on the subject.

[This message has been edited by KJohnson (edited 05-18-2000).]

[pjkoehler]

The Q&A's cited by KJohnson are unfortunately ambiguously framed. For example the first question asks "What is the IRS position on elective deferrals from certain payments following the termination of employment . . . ?" Is this asking whether a deferral election may be made after the termination of employment? Or is it asking whether amounts withheld from compensation for services performed while employed pursuant to a valid deferral election may be contributed after the termination of employment? It could be read either way.

Consider an employee with a valid deferral election in effect who receives his final paycheck at the end of the pay period in which he terminates. If he terminates prior to the last day of the pay period, does this mean that no amount from that paycheck may be deferred? Even though the compensation was paid for the performance of services while employed?

Also, as a legal matter, the salary reduction agreement is not rendered void or invalid merely because of the employee's termination of employment. It probably causes the agreement to terminate upon the employer's full performance. But unitl then the contract remains executory. Generally, the employer is obligated to contribute all amounts of "compensation" subject to the election to the plan, or it will be in breach. The question we are grappling with, and for which there is no answer that is free from doubt, is: what is "compensation" subject to the election? Is it restricted to "compensation" that is made currently available on or before the employee's termination, or is it "compensation" with respect to which the employee is entitled to payment for the performance of services for the employer prior to termination, even if the compensation does not become currently available until shortly after termination?

As a practical matter, "severance pay" is often paid in a lump sum on the employee's actual last day of employment. I think it is reasonably clear that, so long as the plan's definition of "compensation" includes "severance pay," the employer would be obligated to contribute the resulting deferral amount.

[This message has been edited by PJK (edited 05-18-2000).]

[KJohnson]

PJK--I follow your logic, I am just not sure that the IRS agrees with you. I don't think there is much ambiguity in the statement:

"If payments classified as above [severance pay and accumulated vacation pay] are paid PRIOR to the termination of employment, the participant can defer from those amounts (assuming the plan otherwise allows such elections). If the participant has separated from service and these amounts are paid at a later time or over a period of time, no deferrals may be made."

Thus, at least in this comment, the IRS is stating that it is the employee's status at the time of payment rather than election that is determinative.

I suppose that the IRS could find support for this argument in the definition of a cash or deferred election in which an employee must direct the employer to either--

A) provide an amount to the employee in the form of cash or some other taxable benefit that is not currently avialable, or

b) contribute an amount to a trust...

Severance pay arguably would not be available for such an election because amounts paid after the termination of employment would not be amounts provided to an "employee". The 401(k) regs specifically incorporate the 410 regs on the definition of "employee" which is an individual who "performs services" for an employer. Obviously the use of the present tense is the genesis of the "active employee" requirement referenced in the IRSs comments at the ASPA conferences. [The 410 regs also define a "former employee" as someone who as ceased performing services as an employee for the employer.]

I like PJK's analysis and hope it is correct, but until the IRS comes out with definite guidance (or at least retreats from its prior statements) I would still think that it would be advisable to be specific in you plan that amounts can be deferred from severance and then "flag" the issue in your cover letter to the IRS when you seek a determination letter.

[Kirk Maldonado]

I have to agree with KJohnson.

The ABA has presented this question to the IRS a number of times (in a format similar to that used by ASPA), and the response that the IRS has consistently given is that once the employment has been terminated, no more Section 401(k) contributions.

[pjkoehler]

Sounds like a "battle of the informal comments." I'm actually surprised that either the ABA or ASPA would have been satisfied with posing such a question that invites a knee-jerk response with a negative impact on plan design flexibility. I thought they were a little more sophisticated, or at least a little more taxpayer-oriented, than that. I mean at least the question keeps popping up among the practioner community, which is evidence that it's a grey area. Maybe at the next convocation someone will ask the Service to reconcile this position with (i) the safe harbor definition of "compensation" set forth in Reg. 1.415-2(d)(11)(i) which includes any form of compensation for which the employer is required to furnish the employee a written statement under Sections 6041(d), 6051(a)(3) and 6052, and is sufficiently broad to include severance pay, and (ii) the absence of any such blackline rule in the regs or other official guidance? Asking simplistic questions in the abstract about an area which can be pretty fact-bound, really doesn't provide much clarity, without follow-up questions.

[Kirk Maldonado]

I don't know about ASPA, but I think that most attorneys that are actively involved in the ABA would be offended if they were viewed as nothing but shills for their clients. Because the people are spending their own spare time on the ABA matters, my experience is that people are trying to find out what is the right answer, not just what their clients want to hear. In 18 years of working on ABA matters, Ihave found that the attorneys generally try to do the right thing, whether that helps or hurts their clients.

[Guest]

I don't think looking at the definition of compensation is the way to approach this issue. If you work your way through the definition of "employee", "eligible employee", "former employee," etc. in the section 401(k) and 410(B) regs (as I think was done by a previous poster in this thread) you'll come to the conclusion that former employees can't make deferrals. The definition of compensation is only relevant after you have determined whether the individual can validly make contributions.

[pjkoehler]

I'm an active member of both the ABA and ASPA. I have observed that it is rarely good practice, whether you're an actuary, a consultant or an attorney, to put an IRS staff person on the spot in a public forum about an unsettled area of law for which there is no official guidance. The chances are extremely remote that his or her off-the-cuff remarks will consider all the nuances and potential issues and they certainly will not have been vetted by the normal internal procedures. The record is replete with retractions and clarifications, and comments that were just plain wrong. What you're likely to get is a knee-jerk response that lowers the speaker's risk of saying anything that might deviate from the most conservative internal thinking on the issue. Since they're being cited here as authority, we all know that an informal public comment by an IRS staff person may have far reaching implications in the absence of formal guidance. It's not a question of offending a practitioner's since of professionalism, it's a question of tailoring the IRS Q&A to avoid illiciting premature or ill-considered comments without follow-up questions that consider diverse facts patterns. The question we are debating here is at least worthy of a private letter ruling, if not a revenue ruling. The logic of the blackline rule being suggested here disregards a valid salary deferral election with respect to compensation earned while employed, but paid one business day after termination of employment. I suspect a significant percentage of 401(k) plan administrators and payroll firms do not apply this rule. If the IRS public comments are dispositive of the issue, ASPA and the ABA should be doing a better job of disabusing the public of any misperceptions.

[Kirk Maldonado]

That is exactly what the questions and aswers that are posed to the IRS are designed to address; unsettled areas of the law. These questions are posed in writing to the IRS, and the IRS representatives have full knowledge of the implications of their responses.

Having been actively involved in the IRS questions and answers programs for over 10 years, I think your perceptions of it are not accurate.

[pjkoehler]

HarryO, if you review the question that started this topic, it is much easier to resolve the issue if the plan's definition excludes "severance pay," which at least one Section 414(s) safe harbor definition does. So if we look and we see that the plan excludes that form of compensation, we know the answer. It's possible that severance pay is paid on the last day of employment. Wouldn't you say that the plan's definition of "compensation" is controlling in that situation?

If, however, the plan's definition includes severance pay, then we have to consider the next issue, which is the one getting so much attention here. If it's paid after termination of employment, was it nonetheless "compensation for the performance of personal services," or was it merely compensation for the loss of a job. If you read the definition of "eligible employee" closely (which, of course, relies upon the definition of "employee) you'll note that it "means an employee who is directly or indirectly ELIGIBLE TO MAKE A CASH OR DEFERRED ELECTION under the plan . . . . [emphasis added]" Your conclusion, however, appears to be that "eligible employee" means an employee who is employed on the date that that the employer makes the elective contribution to the plan. I haven't seen any analysis that explains how we get from the date of the election to the date of the elective contribution as the controlling date on which the employment relationship must exist for the contribution to be considered an elective contribution.

[Alonzo]

The arguments against PJK's position are old "qualified plan" arguments. See Rev. Rul. 73-238, regarding the coverage of former employees in a 401(a) plan. See also 1.401(a)(4)-11(d)(3)(iv)(A)(1), for the update of that rule.

Although the IRS position may not be what we would like, it is totally consistent with the way they have handled employer contributions over the years. Lest we forget, plans are provided for the exclusive benefit of EMPLOYEES and their beneficiaries. (401(a)(2))

------------------

[pjkoehler]

Alonzo, the authority for your argument is seriously flawed. 401(k) plans are deemed to satisfy the nondiscriminatory amount requirement in the first place and are, therefore, effectively exempt from the rule to which you refer. Reg. Sec. 1.401(a)(4)-1(B)(2)(ii)(B). I think it's a stretch to argue that a pre-ERISA, pre-Section 401(k) revenue ruling which considers minimum coverage requirements sheds any light on the subject of what compensation is controlled by a cash or deferred election made pursuant to Section 401(k). More importantly, to what "IRS position" are you referring? None of the commentators have so far advanced the theory that we have anything more than informal comments. Of what official guidance are you aware that details the "IRS position" that considers this issue in the context of qualified cash or deferred elections?

Also, your comments about "employer contributions" actually buttress the argument for permitting elective deferrals after the date of termination. I'm sure we're all satisfied that an "employer contribution" may be, and frequently is, made on behalf of a participant in a qualified plan well after termination of employment. Of course, in pension plans, the minimum funding rules compel this result, but even in profit sharing plans, no violence is done to the qualified status of a plan if it contains a provision that allows the employer to make a contribution on behalf of a participant who say accumulated 1,000 hours of service even if he is not employed on the last day of the plan year for which the employer contribution is made. Keep in mind that the 401(k) regs specifically treat elective deferrals as "employer contributions." Reg. Sec. 1.401(k)-1(a)(4)(ii). There is clearly nothing inconsistent with (i) allowing employers to make discretionary "employer contributions" after termination and (ii) as a result of a valid cash or deferred election. To the contrary, imposing the requirement that the participant be employed on the date of the contribution creates the only inconsistency, for which no principled distinction has thus far been offered.

[This message has been edited by PJK (edited 05-23-2000).]

[Guest]

1. CODA is an arrangement whereby an "eligible employee" can make deferrals. 1.401(k)-1(a)(2)(i).

2. An "eligible employee" means an "employee" who is eligible to make deferrals. 1.401(k)-1(g)(4)(i).

3. An "employee" is defined as an employee under the 410(B) regs. 1.401(k)-1(g)(5).

4. The 410(B) regs define an "employee" as an individual who "performs services" as an employee for the employer. 1.410(B)-9.

5. Moreover, the 410(B) regs provide that an employee becomes a "former employee" on the day after he stops performing services. In addition, the regs say that an individual can be both an employee and a former employee in the same plan year -- that is, he is an employee until he quits and he is a former employee after he quits.

Although this could be a bit clearer, I think this is the legal underpinning of the IRS's position that deferrals cannot be made by former employees. That said, I have received determination letters on plans that expressly permitted deferrals of severance pay.

[pjkoehler]

HarryO, I don't think your characterization of the cited regulatory language is entirely accurate. Unfortunately, the devil is in the details with this stuff.

For example, Section 1.401(k)-1(a)(2)(i) doesn't define a CODA as an "arrangement whereby an "eligible employee" can make deferrals." In fact, it defines a CODA as "an arrangement under which an eligible employee may MAKE A CASH OR DEFERRED ELECTION, with respect to contributions to, or accruals or other benefits under, [a qualified plan]."

Sec. 1.401(k)-1(g)(4)(i) does not define an "eligible employee" as "employee" who is eligible to make deferrals." In fact, it defines that term as an "employee who is directly or indirectly ELIGIBLE TO MAKE A CASH OR DEFERRED ELECTION under the plan for all or a portion of the plan year."

The definition of "eligible employee" considers the existence of an employment relationship as an eligibility requirement only for the purpose of making a CODA Election. Therefore, it's reference to the term "employee," as defined in Reg. 1.410(B)-9, is similarly limited to the timing of the election, not the timing of the employer's deposit of the elective deferral. Clearly, "former employees" are not "eligible employees" and therefore, cannot make CODA elections.

Once a participant terminates he ceases to be an "eligible employee" and cannot make any further CODA elections. Furthermore, he ceases to perform services for the employer and therefore cannot earn any further "compensation." But, there still has to be some intermediate premises (that haven't surfaced yet) in the logic that gets us to the notion that compensation earned while an "employee" as defined in Reg. Sec. 1.410(B)-9, for the performance of personal services and subject to a valid preexisting CODA election is transmuted into noncompensation because the erstwhile "eligible employee" is a "former employee" when the employer gets around to depositing the deferral in the plan's trust.

[This message has been edited by PJK (edited 05-23-2000).]

[This message has been edited by PJK (edited 05-23-2000).]

[This message has been edited by PJK (edited 05-23-2000).]

[Guest JAREL]

If I might be so bold as to enter the arena, what I see here is, I think, the following:

1. All published guidance, when considered together, leaves us with a less than clear answer to this question.

2. All informal answers from officials are consistent - no deferrals from severance pay paid after termination of employment.

... that's all. So, perhaps someone would be so kind as to convince a client to obtain a private letter ruling on the issue. By the time it's published and we can declare a victor, maybe this topic will be finally closed.

[pjkoehler]

Jarel, I second your motion. In the meantime, perhaps a client can be persuaded to engage a law firm to opine in writing that any amount withheld by an employer from an employee's base pay pursuant to a valid cash or deferred election after termination of employment is includible in the employee's gross income in the taxable year in which the amount was withheld regardless of the proximity of the date of termination to the date such pay was first currently available.

[This message has been edited by PJK (edited 05-23-2000).]

[Guest LAB]

I am looking for some information on the the Pension Income Tax Limits Act. I have very skim details but I am looking for some cites or help to get a more descriptive definition and details on this act.